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Yellow Lights Are Flashing

By: Hector Herrera | Saturday, March 1, 2014

While the market indexes continue to go up to all time new high territory,
there are a couple of negative market divergences I have been tracking. As
always, I am not looking to predict market movements but I am trying to look
for clues of when the smart money is quietly leaving the party before it ends.

First of all, stock market prices are extremely overvalued by many measures
at these levels and are completely detached from any fundamentals in the economy.
Middle class Americans continue to struggle with unemployment and stagnant
wages that have been in decline since 2008. At the same time, markets can levitate
for a long time until the real fundamentals in the economy start to matter.
To be clear, at this particular moment price has not given any indication of
weakness, the trend still clearly up.

What we have here is a number of yellow lights flashing which are early warning
signs of liquidity being withdrawn from the stock market.

The above is a weekly chart of the SPY an ETF that mirrors the SP-500 index.
On the bottom panel we have a weekly reading of the NH-NL index.

The NH-NL index is one of the best market indicators. It basically measures
the strength of the market leaders. In this chart, it keeps track of the number
of stocks making 52- week highs minus the number of stocks making 52-week lows
on a weekly basis. What you are looking for is the NH-NL index to move in gear
with the market. When this indicator starts to diverge from price it pinpoints
tops and bottoms in the market. On this particular chart, at point A the SPY
reached a new high while the indicator had a healthy reading of 3110. At point
B the SPY reached a higher high but this time the indicator reading was lower
at 2130, indicating less stocks were making new highs. On Friday, the SPY made
an all time new high at point C but again, the NH-NL indicator made a lower
high at 1720. What this indicator is telling us is that the breadth of the
market is deteriorating and fewer stocks are pushing the market higher.

The next chart shows the ratio between high yield bonds and low yield bonds.
Bond investors are very smart and usually it is a very good idea to pay attention
to what they are doing. In addition to that, the bond market is bigger than
the stock market and often leads it. During periods of risk-on this ratio moves
higher because investors are taking money out of the safety of low yielding
treasuries and moving it to the more risky high yield junk bonds. The opposite
is true in periods of risk-off.

On the above chart we can see that three months prior to the flash crash on
May 2010, this ratio showed a negative divergence. Moving forward, while the
SP-500 was making new highs in the summer of 2011, this ratio had been making
lower highs for five months. Later that August the market lost almost 19%,
the largest decline since the 2009 low. At the present time we see two warning
signs coming from this chart. The first one is while the SP-500 made a new
all time high on Friday this ratio made a lower high and is sporting a two-month
negative divergence. Also, as you can see, the ratio is at a fiveyear resistance.

SUMMARY: While the stock market appears to be healthy making new all
time highs, there are some warning flags surfacing. It appears that fewer stocks
are pushing the markets higher, which is a big negative. While at the same
time bond investors are starting to move funds from riskier junk bonds into
the more conservative low yielding treasuries. Do they know something we don't?

Systemarket is a financial blog that provides alternative stock market investing
ideas through ETFs and growth stocks. Our methodology is based on trend-following
and momentum strategies. The ideas offered are not to be taken as financial
or trading advice but as the first step of research before investing.